Nearly everyone seems to agree, including many economists. Higher prices fuel inflation. economist Without thinking twice. Speaking of Argentina, he wrote:Will Javier Milley’s next move make or break his presidency?(June 19, 2024):
Monthly inflation is likely to rise in June as energy prices rise.
of The Wall Street Journal “Rent hikes loom, threatening inflation prevention”, June 18, 2024. Examples are everywhere.
But if every price increase fosters inflation (a general increase in the price level), then every price cut must threaten deflation (a general fall in the price level seen during a recession). Other things being equal, every price fall in the market is just as threatening as a price increase; every price change bodes ill. Is this strange theory valid? No. The error lies in not distinguishing between changes in relative prices and changes in the general level of all prices, which is inflation (or deflation).
Imagine that there is no inflation or deflation, and the demand for beef increases, all else being equal. As a result, the price of beef rises relative to (say) pork. This is equivalent to saying that the economy has moved on its production possibilities frontier (PPF) toward more beef and less pork, meaning that the cost of beef has become more expensive relative to pork. (The diagram below shows a standard PPF for an economy with two goods. If good Y is beef and good X is pork, the economy has moved from point B to point A.) Between the original situation B on the PPF and the new situation A, any price index (say the Consumer Price Index) must have changed. Whether the index rises or falls depends on the exact quantities of beef and pork, because these quantities are the weights used to calculate the price index. If there is no change, it is a fluke. Therefore, changes in relative prices cannot be used to conclude that inflation or deflation exists.
Inflation, a general increase in the price level, is another phenomenon caused by the amount of money in the economy.
When there is inflation, the price index captures both changes in relative prices and changes in the general price level. You cannot attribute inflation to changes in any particular price. The latter change is partly due to inflation (all prices have risen) and partly due to changes in comparative prices (Relative) affect other prices. Energy prices and rents cannot encourage inflation (or deflation) because they are partly caused by energy prices and rents. Causation works in the opposite direction.
I have written several articles on this topic for EconLog, including a recent article by Editor-in-Chief Ryan Vaughn titled “Increasing Product Prices Don’t Cause Inflation” Price War (Cato Institute, pp. 19-27) provides a more detailed explanation. See my post “Guns and Butter” ” contains another illustration of the PPF concept.
